Economic Perspective

A Monthly Commentary

^July 2010

Positive forces promoting economic recovery still outweigh the negatives; however, the strength of the case in favor a recovery has faded a bit.  The issue isn’t so much that the engine of growth is faltering as it is a few new hurdles have been put in the path to recovery.  A sort of mini storm of shocks – the Gulf oil spill, European debt default concerns, heightened tension between Israel and its neighbors, Iranian nuclear proliferation fears, slowing growth in China, healthcare and financial regulation in the U.S. – have converged to hurt stock performance in the most recent quarter.

Investors are nervous that these issues will tip the economy back into recession.  Historically, however, the path towards recovery often pauses after an initial period of strength but rarely dips into negative territory as occurred in the Great Depression and 1982 recession. The current sluggishness looks to us more like a more typical slowdown in growth rather than a double-dip. 

With June quarter earnings approaching, we will be listening closely for commentary about capital spending and hiring plans.  Economic shocks can lead companies to freeze spending plans that can snowball from sector to sector in a kind of self-reinforcing downturn.  So far, the commentary has been positive.  Companies have kept their budgets intact in order to be prepared for growth later on.

Despite these concerns, the pieces of the recovery puzzle are falling into place.  As a byproduct of slashing costs, corporations have achieved unprecedented gains in productivity.  Declining unit labor costs have led to significant improvements in operating margins and solid earnings growth. The profits-led recovery has been a distinguishing feature of the current economic cycle relative to prior consumer and housing led recoveries.  Inventories, for the most part, are lean.  Another distinguishing feature has been the solid growth in emerging markets and the U.S. set against sluggish growth in Europe.

Consumer spending is rising but has not been the driver of the recovery so far.  As the employment situation gradually improves and people feel more secure in their jobs, a slowly improving picture for wages may help.  Consumer debt is still elevated but as balances decline, consumer spending later on may create a nice tailwind for the economy.

Earnings remain strong. Citigroup reports that 1st quarter earnings for S&P500 companies included 77% with results that exceeded expectations.  We expect 2nd quarter earnings to also show healthy growth.

Consumer prices are contained.  Excess manufacturing capacity and high unemployment are giving companies greater flexibility in managing costs, particularly labor, which is the largest cost input on average for companies.  The Fed seems to be very cautious about raising rates so a near-term increase is unlikely.  Even if the Fed Funds rate were to rise 1% to 2%, however, we wouldn’t expect the economy to experience any noticeable dampening.

Political instability internationally clearly presents a wildcard that might lead to short-term volatility for stocks.   Additional issues the market must deal with this year include the Chinese Government’s efforts to cool growth by imposing constraints on lending, the debt and looming deficits across Europe.  Add to this, massive budgetary issues in the U.S. and increasing regulatory burdens, particularly financial regulation and energy cap and trade proposals. 

We are bound to see further gyrations as we climb our way out of recession and back to more robust growth led by strong corporate earnings offset by lagging job growth and a weak housing market.  Markets in the short-run often overreact to both good and bad news.  In general, however, we are excited to see the prospects of continued economic stabilization and improving market returns.  Economic inflection points often create opportunities to invest in the beneficiaries of growth as the changing economic landscape unfolds.  We will continue to search for these beneficiaries over the coming months.

Frederick J. Linkner, director of research, presents a comprehensive analysis of the economy including sectors, interest rates, currencies, GDP growth and how these might effect Rosenblum Silverman Sutton investment decisions.